THE FISCAL CLIFF

- All governments seek ways to manage up to the next election

Writing on the wall: Ashok V. Desai

The media have been full of something called the fiscal cliff. The United States of America was supposed to fall off it on the first day of 2013 — unless its two political parties could reach an agreement. What does this fiscal cliff mean?

The US has a bicameral legislature like India. It calls its Lok Sabha the House of Representatives, and its Rajya Sabha the Senate. India is divided into 543 constituencies, which are redrawn once in 40 or 50 years at the pleasure of the Lok Sabhagars; members who have got used to being repeatedly elected from particular constituencies are most reluctant to let the constituency boundaries be redrawn. Some constituencies are reserved for scheduled castes and tribes; people voting in those constituencies have their choice restricted to those belonging to these castes and tribes. In the US, the boundaries of the 435 constituencies are redrawn regularly after the census every 10 years. There are no reservations; any American can stand from any constituency. Members of the Lok Sabha serve five-year terms; members of the House of Representatives serve two-year terms.

The Rajya Sabha, the Indian Council of States, has 250 members; 238 of them are elected by members of the lower house and the assemblies of states, and twelve are named by the president from novelists, cricketers, scientists, painters, social activists and so on. Each elected member has votes in proportion to the population of the constituency he represents. Thus, a member of parliament has roughly 10 times as many votes as a member of a state assembly. The Senate, the US equivalent of the Rajya Sabha, has 100 members: two for each state. They are elected just like members of the House of Representatives, by majority popular vote. In India as in the US, the term of a member of the upper house is six years, and a third of the members is replaced every other year.

The Indian prime minister must be a member of either of the two houses, and is elected by the MPs belonging to the ruling party or coalition. So, normally, he will command a majority in Parliament, although he may lose it as Manmohan Singh did when the Communist Party of India (Marxist) and, later, the Trinamul Congress, withdrew support. Even now, the Congress has only 206 seats in the lower house and 70 seats in the upper house, and its whips must negotiate with other parties to ensure that the party does not lose a vote that would lead to the fall of the government — for instance, a vote on a financial bill. The US president is directly elected by the people; so he may belong to a party which does not have a majority in one or both the houses. The Senate currently has 53 Democrats and 47 Republicans; but the House of Representatives has 241 Republicans and 191 Democrats. So President Barack Obama has to win the support of the Republicans for financial bills.

Without their cooperation, a number of things would have happened automatically. First, the US has five income tax rates. George W. Bush had cut them from 15 per cent, 28 per cent, 31 per cent, 36 per cent and 39.6 per cent to 10 per cent, 15 per cent, 25 per cent, 28 per cent and 35 per cent, just to win popularity. Those cuts would have expired, and the tax rates would have gone up to their pre-2003 levels. Tax on long-term capital gains would have gone up from 10 per cent to 15 per cent. He had reduced tax on some dividends to 15 per cent; it would have expired, and the dividends would have just been added to income and taxed at the highest rate applicable to the taxpayer. There is an estate tax of 35 per cent on estates worth $5.12 million or more; it would have gone up to 55 per cent on estates worth $1 million. Unemployment benefits and pensions are financed from a 4.2 per cent tax on wages and salaries; it would have gone up to 6.2 per cent.

Most of the tax reductions were made by Bush to benefit his rich Republican supporters, and their extension, too, would benefit the rich; why should President Obama, who was elected by the poor, want their extension? That is because the rise in taxes would have withdrawn purchasing power, reduced private consumption expenditure, and reduced employment by 3.4 million; the unemployment rate would have gone up from 7.9 per cent to 9.1 per cent.

The compromise reached involves the raising of the limit for application of the highest income tax rate to $400,000 a year for individuals and $450,000 for families. The tax on estates worth more than $5 million would be raised from 35 per cent to 40 per cent. Tax on capital gains and dividends would go up from 15 per cent to 20 per cent.

So Obama did win on a few points. Still, it looks pretty illogical of him to have agreed to the continued low taxes on the rich; why could he not have let the taxes on them rise and spent the money on the poor? That is because proposals to spend the money on the poor would have faced obstruction from Republican members of the houses, and would have involved another political battle, which could have been long drawn. Obama decided not to take the risk, and compromised instead.

For this is not the last battle. The compromise was reached with the Republicans in the Senate; the deal will also have to be approved by the House of Representatives, where the Republicans can still get difficult. And the deal relates only to the budget for 2013-14. It will have a huge deficit, which will add to the public debt. The debt threatens to approach a level where it will become impossible to repay. That calculation is less certain, for it would stretch over many years, and would involve assumptions about gross domestic product growth which would remain very hazy. But the point that has often been made about countries of Southern Europe, that their debt levels approach or exceed limits of repayability, has to be considered for the US as well. Growth — especially growth of output per head — is the key. The US was the world leader in innovation for over a century. Its mantle has slipped; if its rulers had any sense, they would make sure they regain it. But nothing could be further from the minds of American politicians.

If President Obama mentions his woes to our prime minister at the next summit of the Group of 20, the prime minister would no doubt advise him to follow India, which prints money to finance a goodly proportion of its deficit. The US has even greater scope for doing so, for so many other countries use the US dollars to keep reserves. That includes India; something like three-quarters of its foreign exchange reserves must be stacked away in American financial markets. American politicians may seem myopic and idiotic to an outsider, but they do not have a monopoly of folly. Governments everywhere tend to hoard conventional wisdom; when they face unusual situations, they are often at a loss. After all, they are democratic governments; they can plead political compulsions, and they have constituencies to please. So long-term interests of the country take a back seat, economic advisers are kept in back rooms, and governments seek a way to manage up to the next election.